Each multifamily investment in a real estate project deal is unique, so it is sometimes difficult to compare them against each other. One way that you can do this is to compare the different characteristics of risk in order to make an informed decision on which one to invest in. You ultimately want to make sure that the riskier a project might be, that you are getting paid for that risk.
The risk spectrum goes from conservative to aggressive and can be defined either by the physical type of multifamily real estate, but also by the appropriateness of the debt. For example, a property could be considered a sure thing because it is newer and a very desirable place to live, but the debt financing on the property might have a high loan to value like 85% LTV (Loan to Value). In this case, there is probably too much debt on the property making it a riskier proposition. A 65% LTV would be more appropriate and bring it back to being on the least risky side of the risk spectrum.
Like most things about commercial real estate, we have names for the different deal characteristics, and can be listed from least risky to most risky:
- Core
- Core Plus
- Value-Add
- Opportunistic
- Ground-Up Development
Multifamily Investment – Core
This could be considered an institutional quality asset in a major core market such as a class A property that has been fully stabilized and leased for years. It will most often be in a highly desirable or upscale part of town and offer many amenities. These properties usually command the highest rents and the most credit-worthy tenants, so are considered the least risky investment.
These projects are likely well-kept and need very little or no improvements, and have between 45-60% leverage or debt. They provide stable and predictable cash flow, and normally don’t experience significant appreciation in value. In fact, they are already valued pretty highly already.
Investors in this type of deal are those who are seeking capital preservation instead of growth, and will want to hold these positions for a long time. While this may seem less attractive when comparing the investment to high-yielding multifamily real estate opportunities, many see them as desirable investments for the level of risk they provide, especially when considering a choice between investing in a core asset and the stock market or riskier types of real estate investments.
Multifamily Investment – Core-Plus
Core-plus is the next step up on the risk ladder. This is very similar to the core project, but with a little bit more to it, even though this type of project tends to be high-quality and well-occupied. The property might still be sort of new (under 15-years old) but needs some very light property improvements, cosmetic refreshes, or management restructuring, which will create the ability to increase cash flow. There might be a little less predictability than the core deal, but a lot more predictable than the value-add investment project. In fact, think of core-plus as a core project with a slight value-add component.
Multifamily Investment – Value Add
A value-add property could be outdated or unkempt and need physical improvements or repairs due to neglect or operators lacking the funds to make improvements, and could be considered a class B or class C asset. There might also be operational challenges due to poor management and could have higher vacancy rates than other similar properties in a given area. Management problems, occupancy issues, and deferred maintenance are all key characteristics of a value-add opportunity. These projects often have little to no cash flow at the time of acquisition, yet have the potential to yield an incredible amount of cash flow once repairs are made or the management issues are addressed.
A deep knowledge of real estate, and strategic planning and oversight experience are key traits that a syndication operator needs for these types of projects. Some syndicators specialize in value-add properties which is a reassurance that risks will be reduced on this already fairly risky type of opportunity.
Part of the new operator’s business plan might be to increase cash flow over the hold period by improving or repositioning the property. Examples include making physical improvements, increasing efforts to rent vacant units, improving the quality of tenants, reorganizing or improving the property management team, and lowering operating expenses wherever possible. All this usually forces appreciation of value for the project, so when it comes time to sell, investors get to share in the sometimes significant capital gains.
Leverage as high as 75% LTV can make a project riskier, but this is balanced by the higher projected returns, which can be between 7% and 18% depending on the amount of work needed. Other risks include inability to execute the proposed business plan or failing to meet financial projections.
Multifamily Investment – Opportunistic
Think of this as a class C or class D property with a business plan that needs to be on steroids. To realize its potential, this type of project tends to need significant improvements and rehabilitation. Further, the property could be experiencing high vacancies with poor tenant quality at the time of acquisition. This will likely be a much heavier lift than a value-add property, but with much higher risk and rewards.
An opportunistic type of project offers a very high level of return – but only if the business plan is successful – and has extremely high risk, as it has little or no cash flow at acquisition and usually has a very complicated business plan. My hats off to the guys who have the stomach and tenacity for this kind of deal. Operators for these ventures typically use high leverage financing, often at less favorable debt terms and higher interest rates than core through value-add properties. But like I said, IF the business plan is successful, higher returns to investors can be achieved and usually through substantial appreciation in value at the time of sale.
Multifamily Investment – Ground-Up Development
This is sometimes considered the riskiest class of investment and probably does not get the attention it deserves here on Actively Passive, as we are more focused on value-add opportunities. A ground-up development project can potentially produce the greatest level return of any multifamily real estate investment strategy because shrewd developers can tap into patterns and trends for demand, and build to suit specific tenant profiles. But on the flip side, these tend to be the riskiest projects because of the high level of complexity and long projected hold periods without cash flow. Most of any profits to be had come in the form of appreciation in value at the time of sale.
Getting Paid
You’ve heard the phrase “the higher the risk, the higher the reward.” This is very true in the context of the different investment opportunity characteristics. All real estate investments have this trade off. You are trading low potential returns through low levels of uncertainty, with high potential returns through high levels of uncertainty. Where you find yourself on the spectrum will depend on your tolerance level as well as your investment goals.
Core and core-plus investors can expect to achieve annual returns between 8% and 10%. Value-add investments tend to get annual returns between 11% and 15%, and opportunistic and ground-up investments will yield the highest annual returns, often over 20%-25%.
Final Thought
The actual risk of an investment compared to the advertised risk may very significantly, so it is important to recognize these investment characteristics in order to make the decision on the risks you are comfortable with. I think I am safe in saying that if you are reading this, that you want the highest returns possible. But at what cost? If the risks are high, you could lose your whole investment. Alternatively, if the risks are too low, you could be missing out on other more profitable opportunities.
When I was in my 40s, I was a competitive skydiver winning many national and international championships. Mitigating risks was part of the game there too… But that is another discussion altogether.
